Volatility Smirk as an Externality of Agency Conict and Growing Debt

Abstract

Since Black (1976), the source of the stock price volatility smirk has remained a controversy. The volatility smirk is a side eect of agency conict. An important distinction is that the smirk occurs in the optimum, even after agency conict has been resolved. The slope of the smirk is found to increase with the severity of the initial agency conict between management and investors. It is predicted that the higher is the compensation of the manager, the steeper will be the volatility smirk, both for time series and cross sections of companies. These results may help to disentangle the leverage eect from other potential explanations like volatility feedback, the time-varying risk premium, and a down-market effect.